Key Takeaways
- • Tim Eberle, managing director of Waterfall Services at Citco, says clawback risk is rising up the agenda for private market managers and investors as asset realisations are delayed and previously profitable investments face possible write-downs.
- • Clawback exposure is generally higher under American-style waterfalls, where GPs can receive carry on individual realisations before all LP capital is returned, though Eberle says the risk can be mitigated but not disregarded.
- • Growth of open-ended and hybrid structures, and credit strategies in closed-ended funds, adds complexity because income distributions may be treated differently from realisation proceeds within a waterfall.
- • Eberle argues that detailed projections and scenario analysis run ahead of realisations are the strongest means of mitigating clawback risk, and that Excel-based offline modelling is no longer sustainable.
- • Eberle is less convinced regulatory and tax changes will alter managers' preference for American- or European-style waterfalls.
Summary
Clawback risk is moving higher on the agenda for private market fund managers and investors, according to Tim Eberle, managing director of Waterfall Services at Citco, speaking in a video interview with Funds Europe. Delayed asset realisations and previously profitable investments facing potential write-downs are driving the concern. Eberle said that "any day that you are not selling an asset, that asset is becoming more and more expensive from a waterfall perspective," and noted that clawback obligations now feature in his conversations with GPs and LPs to a greater extent than historically.
The distinction between American and European waterfalls is central to the issue. Under an American-style arrangement, GPs can receive carried interest as individual investments are realised. A European-style waterfall requires all LP contributed capital to be returned, along with a preferred return, before carry is allocated. Eberle said clawback exposure tends to be higher under the American model, since a GP may receive carry before the fund has returned all investor capital. Although the names no longer reliably reflect manager geography, managers are tending toward the American structure in order to reward investment professionals and retain dealmaking talent, which Eberle suggested can also benefit LPs.
Eberle identified two developments complicating the picture. The first is the growing use of open-ended and hybrid structures bridging closed-ended private equity funds and open-ended vehicles, which can bring rolling carry release periods, high water marks and loss carry forward provisions into private fund arrangements. The second is the emergence of credit in closed-ended private markets. Credit funds can distribute substantial proceeds from current income, interest and dividends, which may be treated differently from realisation proceeds. Where credit managers take carry on early income, subsequent write-downs or delayed realisations could change final economics.
On mitigation, Eberle said "the role of technology is paramount," arguing that projections and scenario analysis performed well before a realisation offer the strongest protection. Managers may need to test interest-rate assumptions and portfolio markdowns, and decide whether to take all available carry or defer part of it, with deferral affecting preferred-return calculations. Eberle believes offline Excel modelling is no longer sustainable for this volume of scenarios. "The whole point of a waterfall calculation is to align LP and GP interests," he said. On regulation, Eberle is less convinced that changes in tax classification will alter waterfall structures, and says the more immediate challenge is modelling distributions and clawback exposure as strategies grow more complex.
The distinction between American and European waterfalls is central to the issue. Under an American-style arrangement, GPs can receive carried interest as individual investments are realised. A European-style waterfall requires all LP contributed capital to be returned, along with a preferred return, before carry is allocated. Eberle said clawback exposure tends to be higher under the American model, since a GP may receive carry before the fund has returned all investor capital. Although the names no longer reliably reflect manager geography, managers are tending toward the American structure in order to reward investment professionals and retain dealmaking talent, which Eberle suggested can also benefit LPs.
Eberle identified two developments complicating the picture. The first is the growing use of open-ended and hybrid structures bridging closed-ended private equity funds and open-ended vehicles, which can bring rolling carry release periods, high water marks and loss carry forward provisions into private fund arrangements. The second is the emergence of credit in closed-ended private markets. Credit funds can distribute substantial proceeds from current income, interest and dividends, which may be treated differently from realisation proceeds. Where credit managers take carry on early income, subsequent write-downs or delayed realisations could change final economics.
On mitigation, Eberle said "the role of technology is paramount," arguing that projections and scenario analysis performed well before a realisation offer the strongest protection. Managers may need to test interest-rate assumptions and portfolio markdowns, and decide whether to take all available carry or defer part of it, with deferral affecting preferred-return calculations. Eberle believes offline Excel modelling is no longer sustainable for this volume of scenarios. "The whole point of a waterfall calculation is to align LP and GP interests," he said. On regulation, Eberle is less convinced that changes in tax classification will alter waterfall structures, and says the more immediate challenge is modelling distributions and clawback exposure as strategies grow more complex.
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